Why UK firms should link executive remuneration with ESG

Environmental, social and governance is a high priority for investors, which is just one justification for creating the connection, says Mark Walker

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Disclosure obligations 

UK-listed companies are used to financial reporting and in recent years there has been an increased focus on remuneration-related disclosures. This focus has been coupled with an increase in ESG-related disclosure requirements. For example, a firm with a UK premium listing is required to include a statement in its annual report on the extent to which the disclosures, including remuneration disclosures, are consistent with the recommendations of the Task Force on Climate-related Financial Disclosures.  

Sustainability requirements

Looking specifically at sustainability requirements, the UK Corporate Governance Code is clear that sustainability should be meaningfully addressed by requiring the remuneration policies and practices of companies with a premium listing, whether incorporated in the UK or elsewhere, to be designed to support strategy and to promote long-term sustainable success. 

Additionally, under the Sustainable Finance Disclosure Regulation, some financial institutions must also ensure their remuneration policies promote effective management of sustainability risks. 

Finally, the purpose, beliefs, strategy and culture of signatories to the UK Stewardship Guide are intended to create long-term value for clients and beneficiaries leading to sustainable benefits for the economy, the environment and society.

Transparency requirements 

On the governance side, transparency requirements are pushing UK companies to be mindful of ESG when dealing with executive remuneration. The UK Corporate Governance Code obliges a firm with a premium listing to establish formal and transparent procedures for developing remuneration policies and determining remuneration. 

Shareholder engagement 

Perhaps one of the most compelling reasons to think about connecting executive remuneration with ESG measures is growing shareholder interest in ESG outcomes and shareholder engagement in remuneration.

Some 77 per cent of British investors are likely to consider investing ethically. Globally, 88 per cent of investors subject ESG to the same level of scrutiny as operational and financial matters. ESG is clearly a high priority for most investors, and with annual reports on remuneration for UK-listed companies being subject to an annual advisory shareholder vote, and there being a binding shareholder vote on remuneration policies every three years, it is vital that executive remuneration reflects shareholders’ ESG priorities. 

Public recommendations and strategies  

Lastly, public recommendations and strategies may drive a UK company into tying together executive remuneration and ESG. The Investment Association’s Principles of Remuneration state that remuneration committees should consider including strategic or non-financial performance criteria in variable remuneration. The FCA’s current strategy also includes developing a policy approach to ESG remuneration within regulated firms.

One of the most challenging aspects of linking remuneration to ESG objectives is setting objectives that are sufficiently clear, precise and measurable as to deliver the outcome sought. One of the ways of doing this is to set ESG KPIs that can be used as standalone targets for executive remuneration (much like financial targets), or as discretionary objectives for the remuneration committee to consider when quantifying executive remuneration. 

ESG KPIs tend to vary depending on the sector. Financial services companies might focus on progress towards green financing commitments, whereas construction firms might focus on occupational health and safety. Nevertheless, there is plenty of choice for companies looking to implement KPIs in respect of each of the ‘E’, ‘S’ and ‘G’ components. 

In the ‘E’ sphere, typical KPIs include reducing carbon emissions, increasing the use of renewable energy, achieving net zero targets and reducing food waste. Common ‘S’ KPIs relate to investing in communities, increasing leadership diversity, improving occupational health and safety and accessibility, staff education and training, and data privacy. ‘G’ KPIs are less common, but they are still important. These could relate to compliance, prevention of corruption and bribery, reporting and communication, or risk management. There are also KPIs that combine all aspects of ESG such as sustainable production and supply chains and responsible sourcing.

In future, public demand will require companies to be seen to be addressing ESG issues. Many will need to look at their remuneration policies and practices through an ESG lens. 

Mark Walker is of counsel at CMS